Is Today's Russell 2000 On the Brink of a Correction?

Most traders that lived through the NASDAQ bear market in 2000 - 2002 have seen the relationship between that decline and the decline from 1930 - 1932 in the Dow Jones Industrials. If you've never seen the overlay, it's remarkable how synchronized the markets traded on the upside and the downside.

click to enlarge

In 2003 and 2004, a lot of traders continued to overlay the Dow from 1932 - 1934 to the NASDAQ in 2003-2004 to predict a strong rebound. While initially this relationship held up, it eventually broke down. The Dow from the 1930s rallied much more strongly than the NASDAQ, which has put up uninspiring returns for the past three years.

Despite the fact the NASDAQ decoupled from the DOW overaly, It's time to revisit the 1930s once again. The Dow Industrials encountered a sharp breakdown in 1937, which corresponds to about the current time frame. But instead of comparing the 1930s DOW to the current NASDAQ, I'll use the Russell 2000. The Russell 2000 index has in fact rallied much in the same way the Dow rallied from 1932 to 1937. Both indexes had strong moves off the lows, consolidated their gains for about a year and went on to strong gains for the next four years.

If this relationship holds up, the time may be near for a sharp correction in small cap stocks. This small cap bull has been with us for much longer than most investors imagined. As Mark Haines points out every morning on CNBC, every macro analyst has been calling for a large cap rally for the past four years. But by all measures, small cap stocks have outperformed large caps for almost seven years. That, of course, doesn't mean the trend can't come to an end. Small caps are relatively expensive compared with most other US stock classes. And small cap stocks won't benefit as much from a weaker dollar as their large cap brethren.

So while the small caps have rallied to new highs and look to have recovered from their March swoon, keep in mind the Dow 1937s overlay, just in case we see another sharp correction down.